Finding the REIT Value

The past few years have seen a dramatic increase in the number of real estate firms tapping Wall Street for capital. In many cases, these companies have chosen to go public by reorganizing themselves as real estate investment trusts or REITs. REITs are required to pass along 95% of their earnings to shareholders, and real estate executives like the structure since it exempts the firm from having to pay income tax at the corporate level. The present and future value of the REIT as a real estate investment vehicle, however, has rarely been closely examined.

That is just what Joseph Gyourko, Director of the Samuel Zell and Robert Lurie Real Estate Center at Wharton and Todd Sinai, an assistant professor in the school’s Real Estate Department, set out to investigate. In a paper titled "The REIT Vehicle: Its Value Today and in the Future," the researchers point out that the Achilles heel of REITs is the difficulty of running a growing, capital intensive operating company without the ability to retain earnings at will. Still, REITs do have real tax advantages. For example, since they shield firms against corporate taxation, they do not have to engage in costly tax avoidance strategies. REITs are also a net benefit to the real estate industry. "In 1997, REITs retained $2 billion in cash," says Prof. Gyourko. "We estimate that they could have retained nearly $7 billion if unconstrained by the 95% payout rule."

Gyourko and Sinai say their research points to important insights for real estate executives. Among them:

The REIT shield against the corporate income tax is worth about 4% of total industry market capitalization.

Added capital raising costs associated with being a REIT reduce the net benefit of the REIT structure to as low as 2% of market capitalization.

The benefits of the REIT structure are higher for low payout ratio firms. For firms with 60% payout ratios the REIT structure is worth up to 8% of equity market capitalization.

The REIT vehicle can be made more valuable by increasing the share of tax exempt and tax deferred investment. These investors do not find a high dividend flow burdensome for tax reasons. Increasing the share of tax exempt or deferred investment to 40%, the fraction existing in the broader equity market will more than double the value of the REIT format.

As a result, Gyourko and Sinai conclude that even for large, growing companies with significant capital needs due to acquisition or development programs, an alternative to the REIT format is unlikely to prove financially superior.

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